Over the past few years it’s become an annual rite of passage for various talking heads/economists/pundits/etc to make bold predictions that interest rates will rise in the coming year. In years past, this has been strictly a prediction – getting in front of the move before it happens, so to speak. This year, I’m more apt to believe them for two reasons:

1-The move is already taking place and has been for a while2-The market is generally responding to events by sending rates higher, not lower as it had for several years

Today, I want to focus on the impact to residential real estate in a rising rate environment. Conventional wisdom is that when rates rise, home ownership becomes more expensive which means that marginal buyers are more likely to rent. This is typically great news for multi-family rents (if not values since residual cap rates tend to rise along with interest rates) and NOI. This cycle could be unique though as we are at the likely end of an epic luxury apartment development boom that should lead to softening rents at the high end of the market even if marginal buyers decide keep renting. As Laura Kusisto reported in the Wall Street Journal last week:

Landlords of upscale properties across the U.S. are bracing for rough conditions in 2017 that will likely force them to slash rents and offer deep concessions as a glut of supply brings a seven-year luxury-apartment boom to an end.

The turnaround follows a more-than-26% jump in U.S. apartment rents since early 2010, far outstripping inflation and income growth. But in 2016, rents rose a modest 3.8%, a significant drop from the recent high of 5.6% year-to-year growth in the third quarter of 2015, according to a report to be released Tuesday by MPF Research, a division of RealPage Inc. that tracks the U.S. apartment market.

Developers in New York are already offering up to three months of free rent on some projects. In Los Angeles, some landlords are offering six months of free parking, and some in Houston are waiving security deposits. Meanwhile, MPF Vice President Jay Parsons said he expects little or no rent growth in urban rental markets this year.

“This will be a very challenged leasing environment almost everywhere,” Mr. Parsons said.

The slowdown, he said, is being driven not by a pullback in demand but rather a flood of new apartments. Demand for urban properties jumped after the housing bust as young, high-earning professionals eschewed homeownership and flocked to big cities. Developers responded by focusing most of their efforts on high-end properties.

I want to be 100% clear here: the units that are being added in urban markets like NY, LA and SF are much-needed and will be absorbed over time. However, they need to be leased in order for the landlords to pay their debt and stay profitable and that is increasingly difficult when a tidal wave of similar luxury product hits the market at the same time. Again, from the WSJ:

More than 50,000 new units were rented by tenants in the fourth quarter in the U.S., six times the number in the year-earlier period. But that demand was overwhelmed by the 88,000 new units that were completed in the quarter, the most since the mid-1980s, according to MPF.

That gap looks set to widen in 2017. More than 378,000 new apartments are expected to be completed across the country this year, almost 35% more than the 20-year average, according to real estate tracker Axiometrics Inc.

Ironically, home supply is still relatively low, even as rates are rising. This means that there is a good chance that home prices will merely level off. It’s difficult to see them falling much without inventory increasing substantially from where it is today. Affordability will continue to take a hit with higher mortgage rates but home sale and start volume could increase if lending regulations are lifted and incomes continue to rise in the entry level segment of the market

However, that’s only part of the story. For all off the talk about the apartment boom, it’s been highly focused on a relatively narrow sliver of the market – the high end. As Kusisto continued in the WSJ:

Most of the new construction in recent years has been on the high end. Of 189,100 multifamily rental units completed between the fourth quarter of 2015 and the third quarter of 2016 in 54 U.S. metropolitan areas, 84% were in the luxury category, according to CoStar Group Inc., a real-estate research firm. The firm defines luxury buildings as those that command rents in the top 20% of the market.

For apartment units currently under construction, renters would need to make at least $75,000 a year to afford 88% of those units, compared with 37% of apartment units overall, according to CoStar.

The New York area alone will be flooded with nearly 30,000 new apartments in 2017, double the historical average, according to Axiometrics. Roughly 85% are luxury units.

Rising rents in the past few years have helped buoy the housing market by making home purchases more attractive. Home-price appreciation is outpacing rent growth in all 23 of the metropolitan areas tracked by a national index produced by Florida Atlantic University and Florida International University.

But the flattening of rents in 2017 could shift the financial equation back toward renting, posing potential challenges to the housing market, which saw record prices in October.

That is not a typo, a whopping 84% of the units completed between the 4th quarter of 2015 and the 3rd quarter of 2016 were indeed in the luxury category. This is about as lopsided as it gets. Do you really think that 84% of potential renters in urban markets are in the luxury $75k of income and up category? I certainly don’t and the result is a massive imbalance in the market where high end rents are flat or falling while rents for class-B or lower rental units are soaring. The problem is that most tenants in lower-end units don’t have the finances to buy a home and there is little if any new class B rental product coming to market.

That leaves us with conditions that favor flat home prices with some potential increase in volume at the entry level (again, assuming that mortgage credit loosens) and other segments where affordability is still relatively strong with flat rental growth at the high end of the market. At the same time the low to mid tiers of the rental market are likely to continue to experience rental growth that won’t abate until more inexpensive units come on line. 2017 is going to test conventional wisdom about the impact of interest rates on residential real estate. We will soon find out if supply or cost of capital is a more powerful factor in determining housing cost in the current cycle.